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5 Tips for Avoiding Income-Investing Pitfalls

When investing for income, follow these tips to ensure you stay on the straight and narrow

Holly Cook 27/09/13

When investing for income, follow these tips to ensure you stay on the straight and narrow.

Seeking Income vs. Needing Income
Investors often mistake seeking income as an investment strategy (i.e. a value strategy rather than a growth strategy, or seeking income for the purpose of diversification) with investing to fill a particular income gap in their household balance sheets. The appropriate investment strategy will depend on the results of personal due diligence. As with all investment strategies, there will be a trade-off between the level of income desired and the level of investment risk one is willing to take to achieve it.

When it comes to investing to generate regular income contributions, relying on yield-generating assets such as dividend-paying equities, bonds or funds isn’t the only option available. Investors can also gain exposure to capital growth investments, from which regular capital withdrawals can be taken as ‘income’.

Inflation and Capital Erosion
Consider the impact of inflation and plan for the real return on your investments, rather than the nominal. It can seem all too easy to buy an annuity and forget the level of income erosion that inflation can inflict on returns. As current savers know only too well, in an inflationary environment cash account interest rates may yield negative real returns, so invested assets need to work that much harder.

It can be tough to choose between sticking with cash and accepting capital erosion, or exposing capital to higher levels of investment risk. Thus, cautious investors tend to be those most likely to suffer in an inflationary environment where low interest rates are maintained.

The Tax Man
Tax is often one of the biggest challenges for income investors, particularly those with earned income in addition to their investment income. Careful planning and thoughtful accounting, including dividing portfolios between husband and wife or making full use of allowances and exemptions, can be tools to help plan for income tax implications. Tax efficiency should also be observed in picking an income-yielding investment strategy. Investors who want to opt for the certainty of fixed levels of income withdrawals need to be mindful of their capital gains allowance—a capital growth and withdrawals strategy can be attractive to an investor willing to stick within the ranges of capital gains allowances.

Traditional Asset Classes and Diversification
In the past, guaranteed income bonds and guaranteed distribution bonds were popular products for income seekers but the more traditional asset classes of cash, bonds, equities and property tend to be the recommended tools of today’s income investors. Diversification amongst these asset classes is key. For example, the outlook for property might not look particularly attractive, but allocating a portion of one’s portfolio to real estate can provide welcome diversification from a risk management perspective, thanks to the asset’s correlation characteristics compared with other holdings.

Local Investing with a Global Navigator
The UK tends to be the main port of call for British equity income investors. Dividends paid by UK companies are often higher than those paid internationally, for a variety of historic reasons including the tax environment. It’s worth noting that the international nature of FTSE 100 companies (approximately 70% of their revenues are generated outside the UK) means that even those who think they’re investing solely in the UK are in fact tapping into international opportunities. Investing internationally for income can be a job best left to the fund managers, who can more easily adjust their asset allocations depending on the economic environment.

 

Holly Cook  is Managing Editor of Morningstar.co.uk

About Author Holly Cook

Holly Cook  

is Manager, Morningstar EMEA Websites